The international economy in 2014

Lowy Interpreter

Let's start with the global economic outlook. A common view is that advanced economies are at last on the mend and will take over the running from emerging economies, which have provided much of world growth since 2008.

The US and the UK seem likely to do better this year, because both are shifting out of their strong budget contractions. Similar optimism surrounds Japan, although the promised structural changes (the 'third arrow' of Abenomics) are yet to materialise.

The European periphery can't recover without much more substantial debt forgiveness. This will hold back the rest of Europe, still wallowing under unresolved official and bank debt.

The growth profile of the emerging economies has been widely misread. They slowed to a sustainable pace in 2011 and since then have maintained steady expansion. Even at this slower pace, they are growing twice as fast as the advanced economies. The emerging and developing economies are now slightly larger than the advanced economies (measured in purchasing-power terms), so they will still be the dominant component of future global growth.

Thus the emerging economies are not passing the growth baton onto the advanced countries, and we'll still rely on emerging countries to keep the world growing. They are, of course, a mixed lot. India and Brazil have fallen back to their traditional disappointing growth rates. But the much touted slowing of China didn't eventuate. In 2011 China established a 'new normal' of around 7 per cent growth and is comfortably maintaining this. At this pace it will still double its income this decade.

Most advanced economies still need fiscal adjustment. Budgets remain in deficit and official debt exceeds conventional rules of thumb. There is, however, a chicken-and-egg problem here. The debt and deficits are largely a product of under-utilised capacity. UK GDP, for example, is 5 per cent below the 2007 peak and 12 per cent below the pre-crisis trend.

If GDP could be restored to full capacity, the budget problem would largely disappear. But budget stimulus would exacerbate the short term fiscal and debt position.

What is needed is a clearer differentiation between countries that need rescheduling (the European periphery); countries that have no choice but to undergo the hard slog of budget surpluses; those that can grow their way out of debt; and those that should be borrowing to fund growth-enhancing infrastructure.

Financial analysts will spend much of 2014 staring at their computer screens, trying to divine the profile of the Fed’s quantitative easing taper and then, further away, policy interest-rate rises and the eventual unwinding of QE. 

This unwinding is not technically difficult, but financial markets have demonstrated a capacity to panic when they get confused, which happens often. Last May there was the 'taper tantrum', while in December the actual taper announcement was treated as positive news because it meant that the Fed thought things were going OK.

While talk of currency wars has muted, mainstream economists now (belatedly) accept that volatile capital flows are a problem for emerging economies. Emerging economies will just have to put up with the spillover of extreme monetary policy settings in advanced economies, but they will at least be able to take countermeasures without getting lectured by the international community. Capital flow management and intervention in foreign exchange markets are now accepted as legitimate policy actions in response to excessive inflows.

Some commentators still manage to get into a lather over international imbalances, but the issue has faded away. The main target, China, has now reduced its external surplus to 2 per cent of GDP and its exchange rate has appreciated by 15 per cent. Not much left to complain about.

On the trade front, the WTO showed a fragile pulse of life in Bali last month. But the main action for the moment is with the Trans-Pacific Partnership, where there is growing recognition that comprehensive agreements orchestrated by America may not be in everyone's interests. This could go either way. If the US Congress judges the outcome to be insufficiently biased in America's favour, all that effort could be wasted.

There is also increasing interest in an international approach to taxing multinational service providers (Google, Facebook etc), which can shift profits advantageously. This is a big task, but there is now an acceptance that action is needed.

Financial sector reform has produced voluminous new regulation and the task now is to implement it. Some aspects of global finance will be safer, with tighter capital and liquidity requirements and some restrictions on what banks can do. But the main responsibility still rests with domestic authorities. Where these are diligent and competent, finance will be safe. Where this is not so, banks (and the shadow banking sector) are still an accident waiting to happen – although the memory of 2008 is fresh enough to provide protection for the moment.

Originally published by The Lowy Institute publication The Interpreter. Republished with permission.